Japanese interest rates could spike or the yen could drop by 20 to 25 per cent, according to
Richard Howard
, global strategist at ­Dallas-based hedge fund ­Hayman Capital, which correctly predicted the United States sub-prime ­debacle and the European debt crisis.

His prediction comes as investors are piling into bets that the Japanese currency will lose ground against the US dollar. So far these bets are paying off, with the yen on Tuesday falling to its lowest level since May against the US dollar, which helped push the Nikkei 225 index to its highest level in nearly six years. The Japanese sharemarket eased back on Wednesday, as the yen clawed back some lost ground.

In an exclusive interview with The ­Australian Financial Review, Howard, the son of former prime minister John Howard, highlighted the risky economic policies being pursued by Japanese prime minister
Shinzo Abe
. “Abe is not generally regarded as a deep economic thinker. He’s tended to concentrate on national security and geopolitical issues but he made reflation and the rebirth of the Japanese economy a central plank of his election campaign," Howard says.

“It’s likely that there are practical reasons for this. Abe no doubt realises that he’s reaped a lot of political capital from the recovery in the Japanese economy, and the strong performance of the equity market since his election, and this will allow him to pursue other items on his agenda.

“Also, to the extent that Abe believes that Japan’s destiny is to be the counterpoint to China in the Asian region, the country needs to reclaim its position as a global power, and a strong economy with a reborn industrial base is part of that. There’s also a psychological element. Abe comes from a powerful political family – his grandfather and father were former cabinet ministers, and Abe himself was also prime minister between 2006 and 2007."

BOJ making ‘enormous step change’

Howard argues that the Japanese central bank is playing a “hugely important" role in helping Abe to deliver on his pledges.

“When the Bank of Japan announced on 4 April that it was committed to achieving a 2 per cent inflation target over the course of the next two years by doubling the monetary base and doubling the amount of Japanese government bonds it held, this represented an enormous step change.

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“The Bank of Japan’s new asset-buying program is roughly the same size as that of the US central bank. The US Federal Reserve is buying $US85 billion of assets each month, and the Bank of Japan is buying 7 to 8 trillion yen – but the Japanese economy is only one-third the size of the US. That means that the Bank of Japan is 2.5 to 3 times as aggressive as the US central bank when it comes to QE."

Howard says the strong rise in the Japanese sharemarket and a steep fall in the yen over the past year largely reflects an inflow of foreign capital into Japan. But, he says, for Abe’s policies – dubbed “Abenomics" – to work, there will have to be a shift in the behaviour of Japanese institutions.

“One of the things we’re waiting to see is whether there’s a change in the attitudes of domestic money managers.

“So far we haven’t seen a commitment on the part of domestic institutions to significantly increase their exposure to Japanese equities or to increase their exposure to foreign equity or capital.

“That’s partly because, in recent years, Japanese government bonds have delivered real returns of 2 to 3 per cent, which are acceptable compared to returns on other Japanese assets. But now that inflation is starting to move to 1 per cent, real yields are now zero or negative."

As a result, Howard says Hayman is concerned that Japanese capital markets are mispriced. “We used to be primarily ­concerned that the Japanese government would not be able to sell its debt very cheaply and easily, but that’s changed because the Bank of Japan has decided to purchase more bonds than are issued by the Japanese government each year.

“But if people believe that inflation will hit 2 per cent, yields should be in the 3 to 4 per cent range. And we don’t think that capital markets are set up to deal with changes in rates of that magnitude. We still believe that interest rates are being mispriced in Japan because of the inflationary and credit risks inherent in the economy."

Big drop tipped for yen

Howard says he expects that this ­mispricing is likely to be corrected either by a steep rise in Japanese interest rates, or a hefty drop in the value of the Japanese yen.

“The Japanese currency could fall to ¥120 to ¥125 to the US dollar [from around 100 at present] in the course of the next year and a half. And the Japanese government doesn’t mind pursuing these adjustments through a significantly weaker exchange rate."

Howard also predicts that the US Federal Reserve is likely to start tapering its $US85 billion a month bond-buying program (known as quantitative easing or QE) at the end of March next year.

“The taper is symbolic because it’s a shift away from peak easing, and it inevitably begins the process of relative tightening. Although the Fed is trying to make a distinction between slowing its asset purchase ­program and raising interest rates, there is a logical certainty that the beginning of the taper brings us one step closer to the process of raising rates."

He adds, “We’ve now had asset purchases by the Fed since March 2009 – that’s four years of balance-sheet expansion and one year of open-ended QE for something that was regarded as a stop-gap emergency measure. The move to start normalisation represents a significant challenge.

“One thing to appreciate is that we’re now a long way from where we began.

“The cost of capital has been falling ­relentlessly, because people see it as cheap and plentiful. It’s ­difficult to see how these price levels remain constant when interest rates move up again."

According to Howard, “As peak liquidity starts to ebb, it’s likely we’ll see everything change at the same time. We may not see a sharp correction. We may see a stalling of asset prices. But I’d be surprised if equity markets next year see the same performance as this year – the possible exception being the Japanese market. The Nikkei could rally by 25 per cent to 30 per cent next year because of strong technical factors."

Forecast for back home

As for Australia, he says confidence has picked up following the “transition to a more business-friendly government".

But, he notes, the Australian economy faces a ­challenge as the commodity super-cycle winds down.

“Australia’s growth has to be driven internally rather than externally and it’s not clear that there are very strong sustainable driving forces quite yet."

But he says, “I still see the Australian ­dollar trading in the US80 to US85¢ range longer-term. As global interest rates normalise, that is going to reduce the attractiveness of Australian bonds for foreign investors. And the Reserve Bank is doing its best to make the dollar less attractive. It ­certainly believes the strong Australian dollar is a headwind to domestic growth."

What’s more, “there is a chance that if we see the commodity cycle really slow down over the next couple of years, we could see Australian rates come down to US levels".

Howard is also cautious about Europe. “There’s an enormous amount of optimism priced into Europe, but it’s important to realise that the region has only stabilised. It hasn’t rebounded.

“And the European Central Bank’s review of the banks’ asset quality is likely to highlight problems in the region’s banks, which will probably require them to undertake huge capital raisings and asset divestments in coming years. That will choke off lending to businesses and really test Europe’s ability to recover from current levels."